Fitting U.S. sector ETFs together

Advisers use cheap, tax-efficient funds for swaps

JohnSpence

SAN FRANCISCO (CBS.MW) -- Although some pundits dismiss concentrated sector funds as harmful speculative tools whose only purpose is to humble performance-chasing investors, some financial advisers are adopting sector ETFs for conservative asset allocation strategies, some of which involve tax swaps.

Mike Hunnicutt, a financial adviser at Mullins Wealth Management in Forth Worth, Texas, likes that sector ETFs are tied to benchmarks that have long performance histories to back-test strategies.

"I've started using sector ETFs to build total portfolios," said Hunnicutt, who added that with index-linked ETFs he doesn't have to worry about a potential manager change or the fund straying from its investment philosophy as sometimes happens with active funds.

Some investors and advisers employ sector ETFs to round out portfolios. For example, an employee at a technology firm who holds company stock is highly dependent on the health of that industry sector. While a broad value fund may do the trick in terms of diversifying risk, sector ETFs allow advisers to provide more customized solutions.

"You can end up overweighting certain sectors easily if you like," said Hunnicutt. "And for sectors that are missing in a portfolio, those holes could be filled with the iShares Dow Jones Total Market Index
IYY, +0.50%
One thing I've also been doing is instead of the total market index, using the Dow Jones Dividend Select iShares
DVY, +0.14%
as a replacement. I feel more secure with the stability of high dividend-paying companies, especially in down markets." See previous ETF Investing.

Picking portfolio puzzle pieces

There are currently three complete families of sector ETFs to choose from (not counting the HOLDRs).

The Select Sector SPDRs (Spiders) carve up the S&P 500 into industry sectors, and are managed by State Street Global Advisors. The Sector SPDRs are extremely cheap with an average expense ratio of 0.28 percent, while Barclays Global Investors sector iShares tied to slices of the Dow Jones U.S. Total Market Index are twice as expensive at about 0.60 percent on average.

However, Vanguard recently unleashed a family of even more diversified MSCI sector ETFs that have expenses on par with the Select Sector SPDRs at 0.28 percent.

The Select Sector SPDRs and the Vanguard sector ETFs both use the Global Industry Classification System, which was jointly developed by S&P and MSCI. The iShares use the Dow Jones Global Classification System, so there is some variation in how the indexes define and measure U.S. sectors.

Although there are 10 S&P 500 sector indexes, there are only nine Select Sector SPDRs because there are not enough telecommunications companies in the S&P 500 index to create a diversified ETF.

The Dow Jones and MSCI indexes tend to have more small- and midcap exposure than the large-cap S&P 500 sector indexes.

Source: Morningstar, all data as of 4/6/2004, 3-year returns are annualized

MSCI Sector Index

1-year return

3-year

Energy

31.8%

4.2%

Materials

47.3%

11.1%

Industrials

38.9%

3.97%

Consumer discretionary

42.1%

6.73%

Consumer staples

28.6%

7.72%

Health care

20.1%

2.11%

Financials

39.8%

10.3%

Information technology

48.5%

0.58%

Telecom services

30.9%

-13.1%

Utilities

35.1%

-7.11%

Source: MSCI, all data as of 4/6/2004, all data is index data, not ETF data

Although the larger companies at the top tend to dominate any sector index, the Select Sector SPDRs end up being slightly more volatile because they hold fewer stocks. However, in terms of tax swaps, more volatility may provide more opportunities to swap because the performance of different sectors will vary more.

The Select Sector SPDRs have a higher trading volume, and the underlying companies in the index are highly liquid, which should reduce trading costs even more.

Tax swaps

Some financial advisers are using sector ETFs because of their tax efficiency and low costs, and because there are now three sets to choose from for swaps.

According to Rick Ferri, a financial adviser based in Troy, Mich., and head of Portfolio Solutions, the idea is to buy a specific dollar amount of an index fund each quarter, thus establishing different tax lots. If the market turns down during the quarter, sell the tax lots that are at a loss and simultaneously buy a similar index fund managed by a different fund company to replace the position.

Using a tax swap strategy, you can increase your overall return by saving on taxes while never losing your position in the stock market, he says. The concept of tax swapping index funds is very similar to a common strategy of bond swapping. In a bond swap, you sell a security that is at a loss in your portfolio while simultaneously replacing it with a bond that has similar yield and maturity.

As long as the bond bought is not "substantially identical" to the bond sold, it is not considered a "tax wash" by the IRS. "Wash sale" rules prohibit an investor from taking a loss if a "substantially identical" security is repurchased within 30 days.

The reasoning is that swapping ETFs managed by a different provider and tied to a different benchmark does not trigger the wash-sale rule. However, the IRS has not provided guidance on this issue yet so investors are always better off consulting a tax adviser.

"At this point I haven't used sector ETFs for tax swaps, but I certainly will if the opportunity is there. Tax swapping is very smart strategy to utilize the tax efficiency of ETFs," said Hunnicutt.

New sector Vipers

Financial advisers who use sector ETFs will likely take a look at the new Vanguard sector Vipers because they offer diversity with a high number of MSCI index constituents, and are still able to compete handily with the Select Sector SPDRs in terms of expense ratio.

"I see lots of competition from Vanguard in this area," Ferri said. Ferri believes the new Vanguard sector Vipers could cut into iShares' shelf space.

However, the Vanguard sector ETFs are structured as separate share classes of traditional mutual funds, while the competitors are "stand alone" ETFs. It's not clear yet if Vanguard's structure will provide more or less tax efficiency, and a hot industry debate is already shaping up.

In any case it's something that financial advisers must spend time researching.

"I like ETFs because an investor's funds are not co-mingled with other investors," said Hunnicutt, highlighting the fact that stand alone ETFs offer protection against footing the tax bill when other investors in the fund redeem shares en masse.

However, Vanguard's separate share class structure has some advantages from a tax efficiency standpoint -- to take one example, the ETF can "borrow" any tax-loss carryforwards built up in the conventional fund share class.

John Spence is the editor of www.IndexUniverse.com, a leading source of independent index investing news, research and data. Reach him at jspence@indexuniverse.com.

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